G-23 Change Would Bar Dealer Role-Switch

The Municipal Securities Rulemaking Board filed amendments to its Rule G-23 with the Securities and Exchange Commission on Wednesday that would prohibit dealer-financial advisers from switching roles and becoming underwriters in the same municipal securities transactions.

The board also filed proposed interpretative guidance explaining that a dealer generally should not be considered an FA banned from role switching if it clearly identifies itself as the underwriter during the initial stages of its relationship with the issuer and provides advice related to the issuance of securities while serving as underwriter.

The advice could revolve around the structure, timing, and terms of the transaction as well as the investment of proceeds and whether the issuer should engage in a muni derivative transaction.

The proposed interpretative guidance is new and was not included in an earlier draft the MSRB floated last August.

Another change from the draft involves compensation. Under the existing rule, a dealer is not a financial adviser to an issuer unless it receives compensation. But the proposed amendments would make clear that a dealer can be an FA even if it does not receive compensation.

The SEC will have to seek public comments on the proposed amendments and interpretative guidance and approve them before they become effective. The MSRB suggested that the amended rule take effect for new muni issues six months after the SEC’s approval in order to give issuers time to finalize any outstanding transactions that could be affected.

The amendments would drastically change the current Rule G-23, under which a dealer-FA can become underwriter for the same negotiated muni securities transaction if it terminates its FA role, discloses that the role switch may cause conflicts of interest, obtains the issuer’s consent, and discloses its expected compensation. In competitive deals, a dealer-FA must obtain the issuer’s consent before bidding on the bonds.

“We have come to believe that the conflict of interest — whether actual or perceived — inherent in switching roles from financial adviser to underwriter is not in the best interest of the municipal market,” said MSRB executive director Lynnette Hotchkiss. “By eliminating the potential for role-switching, the MSRB is supporting an environment that will ensure the dealers operate with the highest professional standards when acting in either of these distinct roles.”

SEC chairman Mary Schapiro has been urging the board since last year to forbid such role switching, claiming it is a “classic example of conflicts of interest.”

But the Securities Industry and Financial Markets Association was not happy with the proposal.

“SIFMA continues to believe that the current Rule G-23 represents a comprehensive and balanced approach to potential conflicts of interest, which has a long and successful history of application in the marketplace,” said Leslie Norwood, SIFMA managing director and associate general counsel.

“While we support the MSRB’s review of its rules to ensure that the concerns of the marketplace are appropriately addressed, we did not see a need for the proposed changes in Rule G-23 at this time, particularly with the advent of the newly mandated fiduciary standard for municipal advisers which are currently out for comment by the SEC,” she added. “The SEC’s municipal adviser rules, when finalized, will affect who is covered by this [proposal], and we feel it is inappropriate to move forward with [it] until the SEC finalizes the definition and duties of municipal advisers.”

The amended rule would apply to both negotiated and competitive deals.

Similar to the current rule, the prohibition on role-switching in the proposed amended rule would not cover dealer-FA purchases of newly issued securities from an underwriter for its own account, or for the account of a customer, unless the transaction’s purpose was to circumvent the role-switching restrictions.

But there are other differences. Under the existing rule, a dealer-FA can serve as the remarketing agent for an issue as long as it discloses that there may be conflict of interests, as well as the source and basis of its compensation. But the amended rule would permit the dealer to serve as a successor remarketing agent for the issue if its financial advisory relationship with the issuer for that deal had been terminated for at least one year.

In its filing with the SEC, the MSRB said: “The proposed rule change resulted from the board’s concern that a dealer financial adviser’s ability to underwrite the same issue or issues of municipal securities on which it acted as financial adviser, presents a conflict that is too significant for the existing disclosure and consent provisions of Rule G-23 to cure.”

“Even in the case of a competitive underwriting, the perception on the part of issuers and investors that such a conflict might exist was sufficient to cause concern that permitting such role switching was not consistent with 'a free and open market in municipal securities,’ which the board is mandated to perfect,” the MSRB said. “The imposition by [the Dodd-Frank Wall Street Reform and Consumer Protection Act] of a fiduciary duty upon municipal advisers, which includes financial advisers, made the existence of such a conflict a greater concern.”

Municipal market participants were divided over the MSRB’s earlier draft proposal to amend the rule, which was fairly similar to the proposed amendments.

Non-dealer FAs have long sought a role-switching ban and some issuers have also been uncomfortable with the current rule.

But some dealers and small issuers worried that the ban would reduce competition among dealers that bid for small, often unrated bond issues, and increase issuers’ borrowing costs as a result.

A number of small issuers complained that they cannot afford to hire separate financial advisers and underwriters and that dealers may not want to underwrite their bonds if they cannot also serve as FAs.

The MSRB said it will continue to monitor the new-issue market to see if the amended rule has adverse effects on small issuers.

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